The ABC of overheads

The article 'Overheads: the traditional whys and wherefores', in the September edition of the Student Accountant, covered the basic principles of overhead cost sharing along with an illustration of the traditional processes involved. This second article, aimed especially at students studying for papers 8 or 9, seeks to describe, illustrate and review further developments in overhead cost analysis and cost management, which are aspects of what is generally referred to as Activity Based Costing (ABC). The article should also enable students to contrast ABC with the more traditional overhead cost analysis, and to understand some of the factors affecting its acceptance and implementation.

Activity Based Costing has been a very topical subject, generating a lot of practitioner, as well as academic, interest since the deficiencies in traditional costing methods were especially highlighted some ten years and more ago. A large number of articles have been written on the subject, including several in this journal (see references 1 and 2 for the most recent articles).

Generally, articles on the subject of ABC, written in the main by academics and consultants, have extolled its virtues and have generated widespread interest and awareness. Despite this, implementation of ABC by businesses in the UK has seemingly been slow. For example, Tayles² cites a relatively recent survey of almost 300 manufacturing companies which revealed that only 4% had introduced ABC. This may be because, in Tayles' view, �on occasions some extravagant claims have been made for ABC and some of the costs, difficulties and downside have been overlooked�.

Activity Based Costing The official terminology of the Chartered Institute of Management Accountants defines Activity Based Costing as being �cost attribution to cost units on the basis of benefits received from indirect activities e.g., ordering, setting-up, assuring quality�. There is nothing particularly original in that; indeed, traditional methods of cost attribution would seek to do the same.

ABC has been variously described, ranging from simply a more sophisticated application of the conventional framework for overhead costing, to a radical and novel approach to cost analysis and cost management.

Much depends upon the starting point of the individual business (both in terms of its existing level of sophistication of cost analysis and also the situational potential for ABC) and upon the effort and expertise that is put into ABC design and application.

Traditional methods of overhead cost attribution The traditional methods of overhead cost attribution, which were described and illustrated in the September article, have almost exclusively focused on manufacturing industry. They were developed earlier this century at a time when most manufacturing businesses had a small range of products, heavily driven by manual methods, with relative lack of sophistication and with each product consuming similar amounts of support services.

This resulted in a high incidence of direct costs (both materials and labour) as a proportion of total costs and correspondingly low overhead costs. The level of sophistication of overhead cost analysis was thus not a key factor affecting product costs, which could be used for decision-making purposes but also more especially to satisfy the requirement to include a share of production overheads within work-in-progress and finished goods stock valuation.

A further factor which diminished the importance of overhead cost attribution to products was the development, and acceptance, of marginal costing methods which focus on the contribution that individual products make to the overall fixed overheads and profit of a business.

The background to ABC The conditions which influenced the development and application of traditional overhead cost attribution methods have long since gone; indeed changes in the manufacturing environment and beyond have been occurring at an increasingly faster rate for many businesses.

Within manufacturing, processes have become more complex with an increasingly diverse range of products, often with individual customer specifications. Technology has been a major driver, leading to increased automation. Support functions have expanded, not just in the production environment and not just in manufacturing industry, to meet the demands of more sophisticated customers, and the growing complexity and variety of business.

Cost structures have changed as a consequence. Direct labour costs have declined and been replaced by an increasing burden of overhead costs in all areas of business. Marginal costing information, based on product contributions to much greater fixed costs, have become less appropriate and useful.

At the same time competitive pressures have brought increased focus on all business overheads, which are no longer seen simply as a burden to be minimised. In increasingly competitive and more global markets, where life cycles of products and services have been shortened, businesses seek competitive advantage by:

• differentiating the customer offer, i.e., offering customers perceived benefit in terms of product and/or service in comparison with competitors, at an economic cost; or
• providing a comparable customer offer to competitors, at a cost advantage.

These changes in the external and internal environments within which businesses operate, leading to the increased importance of an enlarged overhead cost base across all business functions, has called into question, albeit somewhat slowly, the traditional methods of overhead cost attribution.

Within manufacturing, for example, attribution of overhead costs to products using indices (such as direct labour or machine hours), which are largely influenced by production output and which largely ignore the factors that increasingly drive costs (such as product size, variety, complexity and change), can distort product costs. Traditional methods tend to over-cost high volume products whilst under-costing those with relatively small volumes. As a consequence, businesses may be unaware that a proportion of their products/services (or indeed customers) contribute nothing to profits or even may erode them.

They may also generally not be in a position to understand and control the increased burden of overhead costs because of the way that they are presented under traditional methods, especially in non-manufacturing areas which have hitherto been relatively neglected and thus not received the management attention warranted by their magnitude. Traditionally, the costs of departments have been measured, but not the quality, efficiency or effectiveness of the service they provide. Focus on individual departments in a typical hierarchical organisation structure also fails to focus on key business processes which frequently cross department boundaries.

Overhead cost analysis thus needs to be more refined if both strategic and tactical decisions are to be based on the best information. Computer technology has provided the capability. Activity Based Costing has gradually developed in response to this need and capability. ABC seeks to help businesses gain competitive advantage, in a rapidly changing business world, through better overhead cost attribution:

• to enable better marketing and investment decisions as a consequence of more accurate and reliable product costs;
• to enable better control of overhead costs, and thus enhancement of value for money, through greater understanding of the factors that drive them.

Activity Based Costing — principles ABC seeks to discover the causal factor, known as the cost driver, which determines the demand for each separate overhead activity i.e., causes the activity to occur. Each activity will be a discrete area of work contributing to an inter-departmental process. For example, order processing may be identified as a discrete activity and the number of orders raised as the key driver of the costs of that activity (Russell1 provides a number of other examples).

Activity costs, and the instances of cost driver occurrence, are measured and are used to determine overhead absorption rates. These are then used to attribute costs to products, i.e., overheads are shared on a basis which is related to the demand that products place on these resources. In the example of order processing, the number of orders raised for each separate product would need to be known for the related overhead to be shared. The costs of activities with the same cost driver can be pooled.

In summary, ABC is a five stage process:

1. identify the various activities within an organisation;
2. determine the key cost driver for each activity;
3. create cost pools to collect activity costs having the same cost driver;
4. measure the incidence of each cost driver for each product/service;
5. attribute the cost of each pool (and activity) to products/services based on the cost drivers.

Undeniably, demand for some production overhead resources is directly related to short term changes in production volume (traditionally termed variable overheads), such as the demand for power to run machines. ABC systems thus still use some output volume related absorption rates. However, changes in the demand for some resources are caused by non-volume related production changes. Also, where a volume-related absorption rate is relevant, in ABC the most appropriate one would always be used. Under traditional methods, and using the example of power costs cited above, absorption on direct labour may actually be used because of the overall labour intensity of the production department.

Using ABC (in contrast to traditional overhead attribution methods):

• costs are identified by activities, which can be linked in processes across departmental boundaries, rather than by cost centre (traditionally a department in a hierarchical organisation structure). There are potentially many more activities (and cost pools) than there normally are cost centres.

• all activities are potentially linked directly with products in contrast to traditional methods where facility and service cost centre overheads are transferred to production cost centres prior to absorption into product costs.

• there is a clear cause and cost effect, in contrast to traditional methods where, even if facility and service cost centre apportionments to production cost centres have a causal relationship, this may well be lost when output volume based methods (often based on direct labour) are used to absorb these overheads into product costs.

Illustration In the September Student Accountant article, an adapted ACCA past examination question was used to illustrate the traditional production overhead cost sharing process. The same example is used below to explore what impact ABC may have on the analysis and on the ensuing information.

It is only practical here to give just a flavour of ABC analysis which will, in practice, invariably comprise a much larger number of activities and cost drivers. The illustration seeks not only to illustrate ABC but also to highlight some of the problems that remain (which will be discussed further later in this article).

In the September article the cost centre expense details and related information, set out in

Figure 1, were provided for a company which was in the process of preparing production overhead budgets and apportioning the overheads to products.

The resulting production cost centre overhead absorption rates to be applied were:

Machine Shop A £16.43 per machine hour
Machine Shop B £6.36 per machine hour
Assembly £4.25 per direct labour hour.

The following additional information is now provided to facilitate ABC analysis:

• indirect wages comprise the following separate activities in each production cost centre:

  Machine Shop A:
  setting-up £12,762 (212 set-ups)
  inspection £4,410 (680 inspection hours)
  

  Machine Shop B:
  setting-up £7,633 (46 set-ups)
  inspection £10,747 (1,680 inspection hours)
  

  Assembly:
  component handling £16,758 (176 batches)
  inspection £14,590 (176 batches)
  
  

• each of the bracketed items above indicates the key driver of that particular activity's costs. Costs for each of the activities can be linked to final products via measurement of each product's use of the key driver.

• consumable materials can be split as follows:

  	Maintenance materials	Other materials
  Machine Shop A	£8,200	£4,600
  Machine Shop B	£12,700	£4,700
  Assembly	—	£2,400
  Canteen	—	£1,200

  The key driver of 'other materials' costs is the value of direct materials (which totals £326,000).

• depreciation of machinery by cost centre is as follows:

  Machine Shop A	£40,000
  Machine Shop B	£33,200
  Assembly	£3,500
  Canteen	£1,200
  Maintenance	£2,500

• space costs (rent and rates, buildings insurance, heat and light) are not to be included in the ABC analysis as there is no clear causal link with the final product. Space costs represent 13.5% of total overhead expenditure (i.e., £45,000 out of a total of £333,310).

• one of the organisation's products (Product X) requires the following resources/activities per thousand units of product manufactured:

  direct materials £18,300

  Machine Shop A:
  400 direct labour hours
  370 machine hours 7 set-ups
  30 inspection hours

  Machine Shop B:
  350 direct labour hours
  1,050 machine hours
  2 set-ups
  70 inspection hours

  Assembly:
  1,000 direct labour hours
  40 machine hours
  8 batches

As far as the facility costs are concerned, space costs are to be excluded from the analysis and machine depreciation is now available by department. The only remaining facility cost is power which will be apportioned, as before, on the basis of the power usage percentages given.

Establishing a link between service cost centre overheads and final products is often difficult, especially where service cost centres also provide a service to each other. A share of the canteen costs can first be attributed to maintenance, with the most appropriate basis being the proportion of labour costs (direct and indirect). Thus:

would be attributed to Maintenance. The remaining Canteen costs are assumed to be attributable to final products on the basis of direct labour hours. Alternatively, they could first be apportioned to cost centres on the basis of total labour costs.

Moving on to deal with the Maintenance Cost Centre labour costs, as before these need first to be shared across the other cost centres, before being attached to final products. It is then assumed that the fairest way of sharing the total maintenance costs (materials + labour) of each production cost centre to produce is on the basis of machine hours. The maintenance costs can be put into a cost pool (within each production cost centre) along with the power costs and machinery depreciation, all driven by the machine hours relating to production.

The ABC analysis is shown in

Figure 2.

It can be seen that, using ABC, not only may the overhead attributed to a product differ (from that attributed using more traditional methods), but also the way that the information is compiled and presented is different, shedding more light on the drivers of overhead costs.

Product costs for decisions A consequence of ABC analysis is greater understanding of cost behaviour within product costs, beyond the simplistic dichotomy of variable/fixed costs. Many overheads, whether production or non-production, are now viewed not as fixed costs but as longterm variable costs, influenced by a number of factors at different levels of business activity.

Tayles² describes a hierarchy of ABC costs (originally developed by Cooper³), at the unit, batch, product sustaining and facility sustaining level, as a means of using ABC systems for the purposes of specific decisions. For example, at the product sustaining level (e.g., decisions on whether to continue with a product) more overhead costs can be attributed (and thus more costs are relevant to such a decision) than at the unit level. In other words products pick up more longer-term variable costs the higher the level of analysis.

An alternative dimension would be to build the hierarchy as groupings of products (e.g., single product, first level grouping (e.g., sub market), second level grouping (e.g., market)). A customer orientation can also be given to such a hierarchy. The key question is what is most useful for decision-making.

It is important to stress that ABC systems are just as applicable in service industries as they are within manufacturing, and can be applied to all functional areas within a business. For example, such systems have existed for a number of years in retailing (conventionally referred to as 'Direct Product Profitability' systems — see Coulthurst⁴), where they are used to support product/market decisions and to facilitate cost management.

Beyond product costing ABC potentially provides more than just increased accuracy of overhead cost attribution leading to improved insight into product profitability. It can also significantly increase the understanding of what drives costs and thus offers greater potential to influence and control costs by activity and across processes. This is not simply about cost minimisation; investment at an appropriate level in support activities to achieve value for money is increasingly seen as a key aspect of business strategy.

Activities can be split into core, support and diversionary.

Core activities are the reason for an organisation's existence and are necessary for the achievement of the organisation's critical success factors, i.e. the factors that an organisation must get right if it is to be successful. Core activities are directly value adding. The focus will be on performing the right activities (process design) to achieve quality and effectiveness of activity outputs. Such overheads should be kept as low as possible but only in the context of business strategy, achievement of which must not be put at risk.

Support activities (for example machine set-up, inspection) make it possible for the core activities to take place and are indirectly value adding. The focus will be more on efficiency (process management), concentrating on the frequency of the activity and the amount of resource required each time. Like external customers, internal customers normally demand as high a service level as possible (e.g., timeliness, frequency, accuracy, fitness for purpose). But they rarely have an understanding of the resource implications of their demands. Value for money analysis, within an ABC framework, assesses whether an internal service is worth the cost of delivering it, and at what level. It is necessary to consider options in terms of frequency, timing, accuracy etc. but knock-on effects across the whole process must be considered.

Diversionary activities (for example correcting errors) are non-value adding and are caused by inadequacies. The focus will be on identifying the root cause of problems in order to minimise them.

Analysis of activities in this way, in an activity based costing framework, can facilitate cost control, and can help to provide the key performance indicators (KPIs) to assess achievement of objectives via measurement against critical success factors. The database thus produced can also become the basis for more detailed forward planning of resources, for budgeting and, as a consequence, for more effective control (Tayles2 expands further on this wider role for ABC systems). Overall, improved understanding of cost causality, and greater cost consciousness among operational staff, should result.

Limitations of ABC There is no doubt that the application of ABC principles to overhead costs provides potential for improved decision-making and better cost management. The extent of the improvement, ultimately to business profitability, will be influenced, and may be limited, by a number of factors:

• The cornerstone of ABC is data; data which does not have to be precise but only accurate enough to help managers take the right decisions. However, management judgement and experience remain key ingredients in the process. Management information supports the exercise of judgement; it can never replace it. For judgement to be exercised, data must be converted to information. This requires analysis and presentation in an understandable form and correct interpretation (and willingness to interpret) on the part of management. Nothing happens until decisions are taken to change things.

• ABC systems utilise, and produce, data/information which is largely historic and in a format, however flexible, which cannot suit all purposes. Decisions need to be based on future expected cash flows, with cost relevance determined by the particular situation of each decision. A particular cost element may be relevant in some decisions but not others. Also, just because a causal relationship is established between a cost driver and an activity does not mean that the cost pool will increase or decrease in direct proportion to the cost driver activity change. This puts even more priority onto the exercise of judgement and the utilisation of experience.

• For many businesses, especially those that have adapted traditional overhead cost attribution methods to changing circumstances, ABC is just a refinement of these traditional methods. For example, a business may already use multiple absorption rates in each production cost centre. The potential for improved accuracy in product costs may be limited, especially if output volume remains a key cost differentiator. Many illustrations in the literature, of ABC systems and their potential benefits, have used examples where the conventional methods have been extremely crude (e.g., a single plant wide rate applied to all overheads — see Russell¹).

• Most of the problems encountered by traditional methods remain. For example, many facilities costs (e.g., rent, rates, insurance, heating, lighting) still need to be apportioned to activities, in the same way as to cost centres using traditional methods, because there is no direct link between them and individual products/services provided to customers. This weakens the causality and raises questions about whether such costs should be excluded from the ABC analysis. Similar problems may apply to other costs e.g., maintenance, materials handling. The key driver of an activity's costs may be clear, and also measurable, but the measure may not be capable of differentiating between one product and another e.g. the handling of material which is used in the manufacture of several different products. Analysis difficulties may also arise as a result of inter-servicing between service cost centres/activities.

• Whilst ABC provides potential for much more sophisticated analysis (i.e., there is potential for a very large number of separate activities and different cost drivers), consideration needs to be given to whether sufficient resources are available, not just to collect and process the data (especially cost driver data by product), but to digest, understand and utilise the ensuing information. In practice, it has been found that benefits are best obtained, but at the same time limited, by relatively simplistic analysis. There is a trade-off between accuracy/detail and system cost/manageability. Priority needs to be given to areas of expenditure offering the greatest potential versus conventional systems of overhead analysis.

• It may be difficult to establish causality for a particular activity. Also, even if the key driver is fairly obvious there will be a number of other factors effecting cost occurrence for the activity, with varying impacts in the short term as opposed to the long-term. There is a lot of muddy water in each cost pool. The selection and measurement of cost drivers is seen as a common problem amongst those who have considered implementing ABC systems.

• A team of dedicated people is required to develop and implement an ABC system, along with regular consultation with, and involvement of, relevant staff throughout the organisation. Substantial investment is thus involved. Such a system also generates on-going costs, not just in maintaining and running the system but to make effective use of the information that it provides. The time, effort and expense involved is cited, by those who have considered but not implemented ABC (or have rejected the idea), as the most common problem (see Innes and Mitchell⁵).
• It needs to be recognised that ABC systems are not generally replacements for traditional overhead attribution systems which will still be required to be maintained, within the manufacturing environment, for stock valuation and financial reporting purposes. ABC systems should rather be seen as more occasional, one-off and largely strategic exercises involving considerable additional resources.

Prioritisation of effort The most significant factor limiting the implementation of ABC systems is seemingly the time, effort and cost involved, especially in situations where projects compete for scarce resources and have to be prioritised. It is important anyway to maximise value for money which is likely to require some prioritisation of effort and a staggered approach to ABC introduction. Clearly, those elements of overhead expenditure which offer the greatest potential in terms of increased product cost accuracy and/or improved cost management should initially be selected for ABC analysis. A number of factors will particularly influence the potential from each activity viz:

• the cost of the activity;
• the key cost driver and the strength of activity cost causality;
• the ability to link the cost driver directly with an organisation's products/services;
• the availability of relevant data;
• the extent of cost differentiation between products (other than caused by output volume).

Conclusion
There is no doubt that ABC is an approach to product costing and cost management which has wide applicability to business organisations right across the industry spectrum and to all areas of overhead expenditure. However, claims about its potential, and about its novelty, have almost certainly been exaggerated, and it remains much talked about but little practised.

The potential to impact upon an organisation's profitability is dependent upon the particular situation and is influenced by a number of factors. Research indicates a positive response from those who have recognised the potential in their own organisations and been prepared to exploit it through the implementation of ABC systems, and who recognise that it is not a panacea.Competitive pressure has frequently been the spur and in situations where existing information was recognised as being seriously deficient.

References

1. Russell D., 'An Introduction to Activity Based Costing', ACCA Student Accountant, July 1997.
2. Tayles M., 'Evaluating the Potential of Activity Based Costing', ACCA Students'Newsletter, October 1997.
3. Cooper R., 'Cost Classification in Unit-Based and Activity-Based Manufacturing Cost Systems', Journal of Cost Management for the Manufacturing Industry, Fall 1990.
4. Coulthurst N., 'Management Accounting in Retail Organisations, (Management Accounting Handbook (Ch 10)), Heinneman, 1992.
5. Innes J. and Mitchell F., A Practical Guide to Activity Based Costing, CIMA, 1998.